Australia's largest mortgage lenders could take a $19 billion hit to their bottom lines if we experience a slump in home prices that is similar in scale as what Ireland experienced – according to global credit rating agency Fitch.
The news isn't worrying investors as the share prices of Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ) are leading the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) higher in late afternoon trade.
The Australian Financial Review reported the results of Fitch's "stress test" on our big four banks which found that a 43% drop in house prices and a 13% loan default rate would cut the big four's profit by $24 billion.
However, payouts from mortgage lender insurance (which is typically required on loans where the loan-to-value ratio is above 80%) will reduce the loss to $19 billion. This equates to about 40% of the banks' operating profit.
It is Commonwealth Bank and Westpac that should have the most to lose as they have a larger exposure to the mortgage market, while ANZ and NAB are better exposed to business loans.
But such a large drop in house prices will be a significant drag on the Australian economy and that actually means ANZ and NAB will probably take a bigger earnings hit as commercial borrowers are more vulnerable to any downturn, explained Fitch.
What this means is that the actual loss suffered by the banks is probably far greater than the $19 billion highlighted in the report as Fitch has not calculated the wider impact of a housing collapse on the big banks.
Don't let the big numbers and Armageddon scenario scare you.
This is supposed to be a good news story as Fitch has concluded that our big banks are well placed to withstand such an extreme (and unlikely) turn of events in the Australia residential market.
Ignoring the wider economic impact from the collapse in home values, Fitch found that none of the big four will breach their minimum regulatory capital requirements, although Commonwealth Bank and NAB will come the closest to the red line.
This is only a stress test and no expert, including Fitch, is predicting such an outcome for our property market despite growing headwinds from record high household debt, rising borrowing costs and tighter lending restrictions on borrowers.
But just in case you like big numbers, the total value of mortgages from the big four banks is $1.3 trillion compared to Australia's gross domestic product (the size of the Australian economy) of around $1.7 trillion.
Having said that, I am not expecting the banking sector to outperform the market in 2018, although the experts from the Motley Fool believe there are three blue-chip stocks that are well placed to deliver outsized returns this year.
Click on the free link below to find out what these stocks are and why they should be on your watchlist.
